Analysis of sale agreements: Warranties and indemnities

Warranties and indemnities are important provisions in many sale agreements. They are utilised in order to support the underlying transaction. Such provisions can be quite powerful and wide ranging in their operation and, accordingly, parties to a sale agreement should ensure they understand their nature and effect before deciding to proceed with a transaction on certain commercial terms.

This discussion is relevant to the sale of shares (and other investment instruments), businesses and discrete assets (whether tangible or intangible).

The Nature and Effect of Warranties and Indemnities

While these terms can take on different meanings depending on their context, in relation to a sale agreement (and this discussion):

1. a warranty is a contractually binding promise given by a vendor in favour of a purchaser in support of a sale; and
2. an indemnity is a written promise whereby a vendor agrees to keep a purchaser harmless against specified losses.

Often, a vendor will make oral or written representations to a purchaser in support of sale negotiations. While there can be some argument on whether such representations are binding on a vendor, warranties which are contained in a sale agreement will ensure that a purchaser has the full benefit of them.

Indemnities are used to support the warranty package and operate to overcome certain limitations around a purchaser’s ability to be compensated for a vendor’s breach of warranty under the principles of contract law.

Warranty Content

The warranty package under a sale agreement will often deal with:

1. title and encumbrances;
2. condition of assets and premises;
3. accuracy of information and forecasts;
4. status of contracts and licenses;
5. compliance with laws;
6. absence or presence of certain facts or matters; and
7. claims and losses in relation to the period of time prior to completion.

A purchaser should ensure, as much as is possible, that it receives what it pays for. Accordingly, appropriate due diligence should be conducted by a purchaser prior to entry into the sale agreement. The warranty package should supplement, rather than replace, this process.

A vendor should ensure that the warranty content does not include matters beyond its understanding.

Warranty Quality

The parties should pay close regard to any qualifications or limitations in the wording of warranties. A purchaser will be seeking the strongest possible warranties in order to protect its investment. Conversely, a vendor will seek the introduction of qualifications where the warranty relates to matters it cannot be certain about.

Limitations on Warranties

Ordinarily, a purchaser will be entitled to take action against the vendor for a breach of warranty for a period of six years following the time at which the breach occurred. In many sale transactions, however, a vendor will seek to limit this period of time to ensure there is a “line in the sand” in terms of its liability in connection with the transaction. The duration of warranties should be closely linked to the risks associated with the transaction and the ability of third parties to bring claims against a purchaser following completion of the sale agreement.

The maximum liability of a vendor should be closely considered by the parties under a sale agreement, particularly where credit support is provided by associates of the vendor.

Further, a vendor may seek to assert that it is not responsible to the extent:

1. the breach relates to information which the purchaser knew about prior to entering into the sale agreement;
2. the parties do not complete the sale agreement;
3. the purchaser suffers loss in connection with its own extraordinary actions or changes in law; or
4. the loss relates to the loss of profit.

Indemnities

If a warranty is breached, a purchaser will seek to obtain appropriate compensation for the loss it suffers in connection with the breach. Generally, a warranty package will be supported by appropriate indemnities whereby a purchaser will be entitled to be kept harmless from any loss or claim in connection with a breach of warranty, including the full amount of its legal costs and expenses.

Often, a vendor entity will be restructured or liquidated following the sale of its main undertaking. In these circumstances, the purchaser may succeed in proving a breach of warranty but will not be able to enforce the judgment against sufficient assets. If a purchaser seeks additional credit support, it should request appropriate indemnities from the vendor’s associates, or those parties which will be in ultimate receipt of the sale price.

Conclusion

The warranty and indemnity package provided by a vendor can have a substantial impact on the risk profile of the parties to a sale agreement. In many cases, these provisions will be of equal importance to the commercial terms. In analysing warranty and indemnity provisions, regard should be had to related provisions such as earn outs (deferred payment of the purchase price), the pre and post contract disclosure of information by the vendor and the level of due diligence undertaken by the purchaser.